How Does Facebook Make Money?

Facebook has finally filed its long anticipated SEC S-1 registration to take the company public. The filing is straightforward, lacking any surprises or innovative accounting techniques that other recent registration statements have offered. Nevertheless, the investment community and the 63 venture-backed companies now in IPO registration — according to The Wall Street Journal — are looking to Facebook to set the tone for IPOs in 2012 after a dismal year in 2011 when the 23 Internet and social media related companies managed an average return of negative 18 percent, according to Bottarelli Research, an investment advisory firm.

Speculation is that Facebook will have a valuation of $100 billion, making it one of the biggest IPOs ever and the largest by an Internet company since Google went public in 2004. Facebook will likely raise $5 billion. A poor showing would be devastating for other 2012 IPOs while a blockbuster opening could boost the entire market. However, Facebook is so different from most other Internet companies in terms of valuation and number of users that it may not be able to brighten the prospects for other companies.

How Does Facebook Make Money?

Facebook is a very profitable company. Revenue in 2011 was $3.71 billion, an 88 percent growth rate over 2010’s $1.97 billion. Net income in 2010 was $606 million and increased 65 percent to $1 billion in 2011. The company derives 85 percent of those revenues from advertising, down from 95 percent in 2010, with the rest coming from social gaming, mostly fees Zynga pays for using Facebook as its platform. Advertising revenue increased 168 percent from 2010 to 2011, $1.9 billion to $3.2 billion.

Facebook is classified as a “controlled company,” which means the board of directors does not have to be independent, nor does it have to have an independent nominating process or compensation committee.

In the IPO the public will be buying Class A shares, with each share carrying a single vote. Company insiders hold Class B shares and each share carries 10 votes. CEO Mark Zuckerberg owns about 28 percent of Facebook and holds 57 percent of its voting shares. He controls the majority of the votes and has final veto power over who gets elected to the board. That will not change when the company goes public, no matter how many new shares are issued and released to the public. The filing states, “Our CEO has control over key decision making as a result of his control of a majority of our voting stock.”

One challenge has already emerged. A few days after the IPO was announced, a California pension fund challenged Facebook over what it sees as a lack of diversity on the company’s board of directors. In a letter addressed to Zuckerberg, California State Teachers’ Retirement System Director of Corporate Governance Anne Sheehan wrote, “We are disappointed that the Facebook board will not have any woman members.”

Zuckerberg will actually be selling shares in the IPO because he will owe a staggering $1.5 billion in taxes when he exercises his nonqualified stock options. He will help the State of California deal with its budget deficit when he pays the state $150 million in taxes.

Facebook had 845 million monthly average users as of December 31, 2011, an increase of 39 percent over 2010. 161 million users reside in the United States, an increase of 16 percent over 2010. Domestic growth is slower than international growth and that has been a cause for concern to some social media industry analysts. In the filing, Facebook did state, “We believe that our rates of user and revenue growth will decline over time.”

Possible Problems

Facebook had more than 425 million mobile monthly average users in December 2011. That number will continue to grow. That is actually a problem, at least in the short term, because Facebook does not sell mobile advertising yet. If the mobile platform pulls users from the desktop, Facebook could see a drop in advertising.

Additionally, Facebook recently starting offering Facebook Pages for businesses. Now that brands can have their own pages offering ads, coupons, and other merchandising offers, they may no longer see the need to purchase advertising on Facebook.

Lofty Goals

Facebook has been credited with helping protestors in various Arab countries spread their message worldwide quickly and at no cost. This success seems to have elevated Facebook’s goals from encouraging people to share pictures and incidents of questionable behavior, to changing the world in a way that no government ever could. “Our mission is to make the world more open and connected, ” states the IPO filing. In a letter that accompanied the filing CEO Zuckerberg, said, “There is a huge need and a huge opportunity to get everyone in the world connected, to give everyone a voice and to help transform society for the future.”

And yet, Facebook acknowledges the whimsical and fickle nature of the world of social networking, perhaps remembering how easily it knocked My Space, once the social networking leader, off its perch. It basically acknowledges that it could fail if people get bored with it and move to the next hot social media outlet. Facebook says it will not meet its growth objectives if “users increasingly engage with competing products; we fail to introduce new and improved products or if we introduce new products or services that are not favorably received.”

As a social and cultural phenomenon, it’s hard to argue with the clout and success of Facebook. But in a purportedly rational financial system, some observers question, “Is a company that offers ‘connection’ really worth $100 billion?”